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Richmond, Calif., Eminent Domain Plan Has Mortgage Industry Shaking

Written by: Shanthi Bharatwaj07/31/13 - 10:06 AM EDT

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NEW YORK (TheStreet) -- Richmond, Calif., earlier this week became the first city to use eminent domain laws to seize "underwater" mortgages and refinance them in an effort to prevent further foreclosures.

The controversial move has little legal precedent and has the mortgage industry up in arms. "The program is ill-advised and likely unconstitutional and will add to Richmond's problems rather than solve them," David H. Stevens, president and CEO of the Mortgage Bankers Association, said in a statement Tuesday.

Eminent domain is the power of the state to seize private property for public use or benefit. The owner is typically entitled to reasonable compensation, referred to as fair market value.

The law has mostly been used to seize property for public purposes such as building roads, highways or schools and other critical infrastructure.

The municipality of Richmond is now testing whether the rule can be applied to seizing underwater mortgages from investors and banks.

Richmond Mayor Gayle Mclaughlin has said that the city is using eminent domain to seize mortgages as a last resort, arguing that banks and servicers have shown little willingness to offer a solution to troubled borrowers in her city.

Home prices in Richmond have recovered about 22% over the past year, according to Zillow, but are still 56% below their 2006 peak.

More than half of the city's borrowers are underwater, according to officials, increasing the threat of more defaults and foreclosures. Foreclosures deeply depress property prices. Preventing them will improve the housing market and the local economy, benefiting the public, she argues.

The city, partnering with San Francisco based Mortgage Resolution Partners (MRP), began sending letters to owners and servicers of 626 underwater mortgages this week.

If the investors do not agree to sell at the negotiated price, the city will seize the property through eminent domain.

As reported by The New York Times, the plan works something like this:"In a hypothetical example, a home mortgaged for $400,000 is now worth $200,000. The city plans to buy the loan for $160,000, or about 80 percent of the value of the home, a discount that factors in the risk of default.